Overview
Economic capital is the name given to a firm wide value at risk measure. It is referred to as capital because it is envisioned as the size of the capital buffer needed to keep a company from bankruptcy to a certain degree of probability.
Types of Risk
The primary types of risk for which banks allocate capital are
Banks may also choose to allocate capital for other risks, such as operational risk, however, these secondary capital allocations are generally much smaller, and also harder to measure.
Basel Formulas
The Basel Committee on Banking Supervision is a committee of banking supervisors who collectively agree on a set of international standards for for bank capital, liquidity and funding. These standards are non binding, however, they are generally followed by member countries. As part of the published standards, Basel produces a set of formulas for managing bank risk. The formulas for calculating bank capital from a set of default models is available in the davinci library.
Capital Allocation
Capital Allocation is the process of taking the bank's total economic capital, and then "allocating" it to each of the banks divisions and/or products.
This process is used in various measures of performance used by banks to assess the performance of its various divisions. (see risk adjusted performance measures)